Stock Splits and their Impact on our Option Contracts

Definition

A stock split is a change in the number of shares outstanding (in circulation). The number of shares is adjusted by the split ratio, e.g. 3 to 1. In this case, 100 shares splits to 300 shares, however the share price is cut in third. Thus, the cost and current value of the investment remains the same, however the number of shares owned increases, while the price per share decreases. This facilitates retail investors to own shares in round lots in that they can buy more shares for less money.

Is a stock split an asset or a liability?

There are those who feel that a stock split will automatically result in a share price increase. Research seems to disprove this theory. However, a split will oftentimes occur after a significant run-up in price, and a continuation of this trend is likely. I give credence to a stock split that occurs after such a price increase, and look at the company’s chart to evaluate the momentum associated with this appreciation. When the technicals confirm the split as legitimate, I consider the event as another plus in that stock’s column of assets. On the other hand, if the chart paints an ugly picture and a split is announced, it is likely that the Board of Directors is desperate and looking to garner interest in a deteriorating asset. In this instance, the split should be viewed as a liability.

A real-life example: SHOO

Early in 2010, SHOO announced a 3-for-2 stock split. This means that for every 2 shares owned, 1 additional share would be distributed. The value of the shares will be worth 2/3 of the current value at the time of distribution so the capitalization (price x number of shares) remains the same. Let’s look at the chart to evaluate whether this split represents an asset or a liability:

SHOO as of 4-17-10

This is a beautiful chart, uptrending with confirming indicators, describes an authentic split and is an asset in the column of parameters for this equity.

Next, let’s view the current options chain. Assume we purchase 200 shares (that rounds off nicely!) and sell the May $55 calls as the stock is trading at $53 per share:

SHOO- options chain

The $55 call generates $165 per contract, or a 3.1%, 1-month return ($165/$5300) with additional upside potential of 3.8% per share if the stock climbs from $53 to $55 and assignment occurs ($200/$5300). Let’s next view the impact this split will have on our covered call position both pre- and post-split.

Pre- and post-split comparison

Pre- and Post- Split Comparison

The major difference is that prior to the split, each contract delivers the conventional 100 shares while post-split each contract will deliver 150 shares. This is known as a non-standard contract. If the split had been by an even number, such as 2 for1, the number of contracts would simply double and would deliver the standard 100 shares. For example, if a $50 stock splits 2-for-1 and we sold one $50 call, after the split we would have sold two $25 calls and our cost basis would be $25, with each contract delivering 100 shares. See page 179 of Cashing in on Covered Callsfor an example of a 3-for-1 stock split.

Conclusion: When the economy is on the upswing and the stock market shows a bullish trend, stock splits are likely to become part of our covered call lives. Since the downturn in the market in 2008, stock splits have been few and far between. With the recovery starting in 2009, investors have witnessed the beginning of a resurgence in splits like the one shown in this article. As the market strengthens we would expect that number to increase. It is important to recognize quality splits from imposters and to learn how the splits impact our option contracts.

Alan Ellman’s Encyclopedia for Covered Call Writing:

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Market tone:

Economic reports leaned to the positive this past week:

Retail sales rose by 1.1% in September double the analyst expectation and the largest 1-month gain since February

As a result of the FOMC assessment that “economic growth remains slow”, Operation Twist” was adopted. This unusual bond-purchasing program is designed to lower long-term borrowing rates to stimulate spending

The trade deficit remained unchanged despite a record gap with China. Some economists believe that China is artificially keeping its currency low to boost its own exports

Congress approved free-trade agreements with South Korea, Columbia and Panama anticipating increasing exports by $13B per year

For the week, the S&P 500 rose by 6% for a year-to-date return of (-) 2.7% including dividends.

Not infrequently you have seen me use the term “cautiously bullish’ when stating my personal assessment of the market direction. When the market was trending down I received many emails asking me “why so bullish?” After it bounced off support and moved back up, many of you inquired “why so cautious?” This is the nature of market pyschology and explains why the VIX has been out of control until recently. I decided to devote part of this week’s article to respond to those valid inquiries:

Why so cautious?:

Markets declined worldwide in the 3rd quarter mainly due to concerns of the European debt crisis

Fears related to Greek insolvency and contagion in the European monetary union remains a major concern

The US consumer is facing high unemployment, excessive debt, declining housing prices and faltering retirement savings

Europe’s ability to buy our goods and services is another concern

Recovery is much too sluggish

Consumer confidence needs to get a boost

Why so bullish?:

Earnings and revenues…our corporations are doing great. This site anticipates another robust earnings season

Housing prices appear to be bottoming

Savings rates are improving

The health of our banks has dramatically improved

Low-interest refinancing has injected more liquidity into our economy

Energy prices have decreased helping both consumers and corporations

US Treasury bonds is still viewed as the safest resting place for global investors

Years ago it seemed so much simpler. Look at a company’s fundamentals and technicals and make a decision. We juggled three balls back then, today we juggle six or more… Greece, Italy, Germany, incompetent and mean-spirited politicians, terror threats, too many wars, an almost depression, investors needing a higher dose of valium and the Yankees losing in the first round!

Assessing Market Tone

The good news is that these challenges can be overcome through fundamental analysis, technical analysis and common sense principles. Once a market assessment has been made a non-emotional investment plan can be constructed. My approach is cautiously bullish, one man’s opinion.

About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies. Google +

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1. If all the four technical analysis indicators are positive, then the stock has good momentum to move upward. It is likely that the stock price will increase further and thus OTM call should be favoured.

2. If these indicators are positive, the stock price should have been increased a lot. The big boy will likely to take profit, thus the stock price will likely to be going down and thus ITM call should be favoured.

We’ve had this comment before. The font size can be controlled with the drop down arrow at the top of the spreadsheet. I use 100% and print it out at that size. See the screenshot below (click on image to enlarge and use the back arrow to return to the blog).

1- You do NOT necessarily totally unwind your cc position if a stock has been removed from the running list. We use the exit strategy principles of the BCI methodology like the 20%/10% guidelines and consider other choices like rolling down. Of course, unwinding is one of those choices but it shouldn’t be based solely on removal from the running list. Now, if you were going to initiate a new cc position, the current candidates on the running list are stronger choices at this point in time. Please note that many of the stocks on our current running list will report earnings during the November contracts.

2- Our policy is to only distribute the report in secured PDF format. The reasons for this are as follows:

• We have to protect our intellectual property
• The results can be recopied and published by persons not affiliated with the Blue Collar Investor organization
• If we sent the report in a different format (i.e.: Excel), the results have the potential of being inadvertently or accidentally changed…giving incorrect results that could impact the investing decisions of our readers.

Good question and one that most investors have struggled with. In your hypothetical, ALL indicators are bullish with strong upward momentum, a big positive. Strike selection, however, is determined by factoring in more information than that. For example, what is your current overall market assessment? If bearish or volatile , I would favor in-the-money strikes. If bullish, definitely out-of-the-money strikes. Also, what is the industry segment rank? If the instiutional investors are favoring that equity’s industry I would be more bullish in my positions. Another major consideration is your personal risk tolerance. Do you need the additional protection of in-the-money strikes to sleep better at night?

Generally, all positive technical indicators will favor out-of-the-money strikes but by factoring in these additional parameters and others we will be throwing the odds in our favor to a much greater degree and that is what the BCI methodology is all about.

A member of our premium watch list for 13 weeks, this stock reported a stellar 2nd quarter earnings report with revenues up 9% and earnings 10% ahead of expectations. This company has had a positive eanings surprise average of 9.5% over the past 4 quarters. Cash reserve is up $60 from last year and analysts project a bullish 15% growth rate. Our premium report shows an industry segment rank of “A”, a beta of 1.02 and a dividend yield of 1.40.

This is the 3rd largest cigarette maker in the US. In the 2nd quarter sales were up 11% and earnings 19% year-to-year. Analysts project an 14% growth rate for 2011 and 11% in 2012. The compnay continues to buy back shares which bodes well for EPS stats. LO is scheduled to report 3rd quarter earnings on October 24th and has delivered 7 consecutive positive earnings surprises. Since going public in 2008, it has raised dividends three times which currently stands at a 4.40% yield. LO trades at a reasonable 13.8 x forward earnings. Our premium report shows a beta rating of 0.57 and an industry segment rank of “A”.

You are looking at the “Last” column which indicates the last time the contract was traded. There is no current bid-ask info on this screen you sent but it should be in the $18 – $21 range. When we see a large discrepancy between the bid-ask spread and the “last” figure it is the result of one of two things”

1- A huge move in the recent share price, but more likely…

2- It has been a long time (perhaps months) since this contract was traded.

One concern with a stop-loss or net credit order is that a stock can “gap down” after an earnings release like Apple did today after last night’s release. A stop-loss does not guarantee a sale at the requested price if the price drops precipitously. Another approach would be to purchase a protective put. You must decide if it is worth the cost and trouble in a covered call acount.

This member of our premium watch list is near a multi-year high. It’s recent second quarter earnings report was 1 penny ahead of estimates as revenues rose by 38%. Analysts are projecting a bullish 18% growth increase. It trades at a reasonable PEG of 1.11. Our premium report shows an industry segment rank of “A” and a beta of 0.81.

I sold the 50 call ooption for dsw and can roll out to the November 50 and get over a 3% one month return. My question is what if the stock drops below 50. At what price do I roll the option versus letting the option expire?

If the stock closes even $0.01 above the $50 strike, expect the option to be exercised. Even if the price is a few pennies below $50 as we approach 4PM EST tomorrow it is possible that the price can jump over the $50 strike a minute or two after 4PM as the final trades are reported. In these situations (within pennies of the strike), if you don’t want the shares to be sold I would roll the option.

This week’s 6-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site and is available in the “resources/downloads” section. Look for the report dated 10-20-11.

We are offering to our members a discount of $5 + FREE SHIPPING for Alan’s newest book: Alan Ellman’s Encyclopedia for Covered Call Writing. The total discount will be $8.75 GOOD UNTIL October 31st. Premium members are ALSO entitled to your everyday premium discount (***enter the Blue Collar store from the premium site). Be sure to enter coupon code “book3”.

For those of you who have already ordered the book, shipment started Wednesday and we are shipping twice a day to keep up with the demand. We are truly humbled by your overwhelming support. At this time, the book is only available from this site but will be available on Amazon.com in the near future. The lowest price will be from this site.

With the stock trading @ $51.35 after market close on Thursday there is a good chance Fran will be faced with a rolling situation if retaining the stock is a priority. Here are the stats pre-market on expiration Friday, October 21, 2011:

Close Oct $50 call @ $1.60

Open Nov. $50 call @ $3.50 (roll out) or

Open Nov. $55 call @ $1.20 (roll out and up)

I fed this into the Ellman Calculator- “What Now” tab:

1- Rolling out results in an intial 1-month return of 3.73% with $135/contract of downside protection OF THIS PROFIT (2.6%:135/5135).

2- Rolling out and up results in an initial (unrealized) 1-month profit of nearly 2% ($95/$5000) with a loss on the option side (red arrow) and a bought up share value increase (blue arrow) on the stock side. If the price rises to the $55 strike, the potential gain is $460 or a total 1-month profit of 9.2%. See the screenshot below for the results using the What Now tab of the Ellman Calculator. Click on the image to enlarge and use the backarrow to return to the blog.

Yes. Chapter 6 titled “Calculations” goes in depth into the Basic Ellman Calculator and the Elite Calculator. There are also screenshots of the calculators in action (as you see in comment # 24 above) throughout the book.

This is a personal decision based on your risk tolerance and market assessment. I’m happy to share with you what I would do: In these volatile market conditions I lean to the in-the-money strikes for the additional downside protection. The $50 call would be my preference if rolling this option. You will still generate a 3%, 1-month return or better and have protection of that profit as well. More aggressive investors may opt for the $55 and potentially end up with a near 10%, 1-month return if the stock passes the $55 strike.

I’ve been doing only in the money strikes for the past two months. It’s the volatility that makes me crazy – one days up couple hundred next day down… You seem to agree. It’s shame this latest run has left $ on the table, but I just don’t trust the market. Comments?

I absolutely agree and that’s exactly how I have been handling my cc investments during this market volatility. It is the right approach for conservative investors with low risk tolerance. More aggressive investors may opt for the out-of-the-money strikes . We would all be more successful investors in hindsight however we must look forward based on the information at hand and with the economic news of the day mixed, global issues unsettled and the market in a trading range having not identified a definite trend (I will highlight this in a chart I created in my upcoming blog article) a cautious approach makes sense to me. We can still earn a nice return with in-the-money strikes.

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